M-LEC: Restructuring Not Bailout

We have witnessed a tremendous backlash against the M-LEC, Super SIV
or whatever other name you choose to call the pooled securitization
vehicle proposed by several banks and supported by Mr. Paulson and the
US Treasury.

While articles in the New York Times, Financial Times and the Wall Street Journal
have all raised concerns over its likelihood of success, the
motivations behind its creation and concerns over "moral hazard," two
particularly snarky pieces showed up this weekend penned by Mr. Ben
Stein (NYT) and Mr. Alan Abelson (Barron's) that warrant comment.

Let
me be clear: I see neither a moral hazard nor a pending bailout in the
form of the M-LEC; what I see is something more akin to the "Good
Bank/Bad Bank" restructurings of the 1980s, where discrete pools of
good loans were hived off of the bad to protect the good from being
subject to perverse behaviors arising from the bad.

This doesn't mean
that the bad somehow get wiped away, forgiven, eliminated or anything
of the sort. What it does mean is pools that, in aggregate, are being
penalized for the credit features of a portion of its assets are able
to access cost-effective financing for those assets that warrant it.
The others, well, they need to be worked out. This isn't crazy stuff.
It's just sound finance. Not voodoo financial engineering. Not some
super complex derivative strategy. At its core it is pretty basic stuff.

One
can use either the Good Bank/Bad Bank analogy or even the tracking
stock/spin-off analogy, where the value of a mis-priced component of a
group of assets is allowed to trade at its own level, bolstering the
value of the combined group. Either way, Messrs. Paulson and Steel are
not out to try and pull the wool over investors eyes, bail out Wall
Street or anything like that. They are merely helping to problem-solve
at a time when, let's face it, the problems are both large and stark.
And they happen to be two very seasoned market participants who get it,
and can certainly add to the collective gray matter required to address
the pain that we'll all inevitably incur.

Now, the ultimate Wall Street player and insider, Henry M. Paulson Jr.,
the Treasury secretary, has bestirred himself to take serious notice of
the credit problems faced by some very big lenders. He wants to create
a bailout fund in which banks that still appear sound buy some of the
debt of the troubled players like Citigroup.

THE deal, as far
as I can tell, is that they buy the most secure levels of debt that
Citigroup and others own, get large fees and allow Citigroup and the
others to keep the debts off their balance sheets. But there are at
least two giant issues here.

One is that it’s a bit too
predictable that Mr. Paulson would basically pooh-pooh the subprime
problems until major Wall Street powers got in trouble and then —
presto! — swing into action. It might have been inspiring had he
stepped up to the plate when smaller players like home buyers were
getting burned, but that’s not really his style.

The other is
that it’s hard to see what good the maneuver would do. Suppose
Citigroup or some other lender has a perfectly good loan to sell. Why
does Citigroup need a big Treasury-sponsored organization to sell it?
They can sell it to anyone right now. The problem is with the
questionable loans. And they seemingly are not part of the plan from
the Treasury.

I
don't know if Ben is running for office, but it sure sounds like it. I
think his characterization of Mr. Paulson's motivations make for good
copy but are too inane for words. Right, he is bailing out his Wall
Street buddies. Mr. Stein, while you don't make much of this subprime
mess most of us do, and the credit markets are gradually waking up to
the longer-term risks posed by the credit crunch, and the amount it
effects Wall Street relative to Main Street is trifling.

So if Mr.
Paulson really wants to help his Wall Street pals there are easier ways
to do it (like to whisper in the ear of Mr. Bernanke - if someone wants
to see a possible moral hazard in action look at Fed policy). And as it
relates to the argument that Citi (NYSE:C) and others could just sell the
well-performing loans, this structure provides a single, ready buyer, a
buyer who is only going to buy if the price makes sense. No firm
planning to be involved with the M-LEC structure is charitable by
nature, and unless the deal makes sense they won't participate.

So I'm
not really sure what to make of your argument except to say that it is
expedient if not entirely possessing teeth. So your entire bailout line
of discussion to me is, in fact, a red herring, and a convenient
vehicle for you to vent your spleen about what really irks you: that
the Government should stay out of all this stuff, period. Now if that
is what you had written I'd have taken you more seriously, but as you
didn't, well, I don't.

And now, from Mr. Stein's bosom buddy, Mr. Abelson from this weekend's Barron's:

Happily, we have in the
person of Henry Paulson a Treasury Secretary who has a keen grasp of
how the financial world works, who understands how crucial bankers and
brokers are to the comfort and well-being of this rich nation. He is
able to make that judgment because so many of them are his bosom
buddies, one of his treasured legacies from the many years he spent
laboring in the vineyards of Wall Street.

Carpers and cynics who never met a payroll and,
indeed, likely never did an honest day's work (you know the types as
well as we do: politicians, journalists, that sort of lowlife) may
snarl all they like about crony capitalism and worse. But decent,
compassionate folk can only cheer the speed with which Mr. Paulson
whistled up a $100 billion bail-out for a posse of banks that found
themselves stuck on a sandbar when the sea of liquidity they have been
so happily splashing about in suddenly went bone dry.

********************

Enter Mr. Paulson, who
put the arm on a number of major banks, even some that had no exposure
to SIVs, to set up a fund with the real catchy name of the Master
Liquidity Enhancement Conduit to help out the needy banks by buying
securities from them, presumably at a discount. The obvious intention
is to reassure the world that everything's hunky-dory and keep the
banks, poor sensitive creatures, from having to show those squishy
assets on their balance sheets.

Our considered view is that the supposed bail-out is
a typical bit of Washington flash: all show and no substance. For a
second, more tempered, opinion we turned to Punk Ziegel's savvy bank
analyst, Richard Bove. He calls it "a horrible idea" that "would do
nothing to solve any subprime-debt questions, mortgage issues, bad
bank-loan problems etc... It would not bail out any bad loans from
anyone, anywhere...It will not solve the liquidity problems where the
SIVs need the most help and it will not reduce the debt problems facing
the economy."

Again
with the snarky sarcasm? Ben and Alan must have gone bowling late last
week and decided to pile on Mr. Paulson this weekend. Again, reference
to a bail-out. Where? The M-LEC is a market-based vehicle being
assembled by financially motivated participants, none of whom is the US
Treasury. So this jargon is simply inaccurate and muckraking, at best.

And as for the balance sheet argument, if analysts are too dumb to take
into account the impact of off-balance sheet assets, be they SIVs,
asset defeasance transactions, operating leases, etc., then they
deserved to fired. Balance sheet footnotes, my friends. Sure, one can
argue over the accounting rules, but any decent bank analyst knows of these deals and their true economic
effects.

That said, I think Mr. Bove's questions are more to the point.
There is no question that the M-LEC solves no bad loan issues on day 1.
If anything, it provides some financing to buy time, but how much value
this really conveys is a mystery to all. And he is also correct that
the detritus is incredibly hard to finance, and will weigh on balance
sheets likely for quite some time. Some may well have to be sold at
huge losses, others will be worked out, while some others may recover
as market conditions improve. That said, it is a big unknown.

I
think the real question is if the M-LEC has enough positives to make it
worthwhile relative to the unknowns. As it introduces friction, it
costs money to assemble for participating firms, especially those
selling assets into the vehicle. And as noted above, it doesn't
directly solve any fundamental credit problems. But it does create a
ready market for high-quality SIV assets, in size, that streamlines the
operational process of generating liquidity relative to selling
discrete assets to many, many buyers. And it does provide an
opportunity for market conditions to improve, possibly enabling some of
the currently distressed paper to recover. And the part that doesn't,
the banks will take some lumps. Lumps that they deserve to take.

So net
net, it might be worth a go. And it certainly doesn't have all of the
negative connotations or motivations put forth by Messrs. Stein and
Abelson. I don't know what someone put in their Wheaties this weekend,
but keep it out of my bowl, ok?